#cfa-level-1 #reading-25-understanding-income-statement

On the top line of the income statement, companies typically report revenue. Revenue generally refers to amounts charged (and expected to be received) for the delivery of goods or services in the ordinary activities of a business. The term net revenuemeans that the revenue number is reported after adjustments (e.g., for cash or volume discounts, or for estimated returns). Revenue may be called sales or turnover.4 Exhibits 1 and 2 show the income statements for Groupe Danone (Euronext Paris: BN), a French food manufacturer, and Kraft Foods (NYSE:KFT), a US food manufacturer.5 For the year ended 31 December 2009, Danone reports €14.98 billion of net revenue, whereas Kraft reports $40.39 billion of net revenue.

Note that Danone lists the years in increasing order from left to right with the most recent year in the right-most column, whereas Kraft lists the years in decreasing order with the most recent year listed in the left-most column. Different orderings of chronological information are common. Differences in presentations of items, such as expenses, are also common. Expensesreflect outflows, depletions of assets, and incurrences of liabilities in the course of the activities of a business. Expenses may be grouped and reported in different formats, subject to some specific requirements. For example, Danone reports research and development expenses as a separate line item whereas Kraft combines research costs with marketing and administration costs and reports the total in a single line item.

Another difference is how the companies indicate that an amount on the income statement results in a reduction in net income. Danone shows expenses, such as cost of goods sold and selling expenses, in parentheses to explicitly indicate that these are subtracted from revenue and reduce net income. Kraft, on the other hand, does not place cost of sales in parentheses. Rather, Kraft assumes that the user implicitly understands that this is an expense and is subtracted in arriving at gross profit, subtotals such as operating earnings, and, ultimately, in net income. In general, companies may or may not enclose an amount in parentheses (or use a negative sign) to indicate that it is a reduction in net income. Furthermore, within a list of items that normally reduce net income, an item that increases net income may be shown as a negative. In this case, the item is actually added rather than subtracted in calculating net income. In summary, because there is flexibility in how companies may present the income statement, the analyst should always verify the order of years, how expenses are grouped and reported, and how to treat items presented as negatives.

At the bottom of the income statement, companies report net income (companies may use other terms such as “net earnings” or “profit or loss”). For 2009, Danone reports €1,521 million of net income and Kraft reports $3,028 million of net earnings. Net income is often referred to as the “bottom line.” The basis for this expression is that net income is the final—or bottom—line item in an income statement. Because net income is often viewed as the single most relevant number to describe a company’s performance over a period of time, the term “bottom line” sometimes is used in business to refer to any final or most relevant result.

Despite this customary terminology, note that the companies both present another item below net income: information about how much of that net income is attributable to the company itself and how much of that income is attributable to minority interests, or non-controlling interests. Danone and Kraft both consolidate subsidiaries over which they have control. Consolidation means that they include all of the revenues and expenses of the subsidiaries even if they own less than 100 percent. Minority interest represents the portion of income that “belongs” to minority shareholders of the consolidated subsidiaries, as opposed to the parent company itself. For Danone, €1,361 million of the net income amount is attributable to shareholders of Groupe Danone and €160 million is attributable to minority interests. For Kraft, $3,021 million of the net earnings amount is attributable to the shareholders of Kraft Foods and $7 million is attributable to the non-controlling interest.

Net income also includes gains and losses, which are increases and decreases in economic benefits, respectively, which may or may not arise in the ordinary activities of the business. For example, when a manufacturing company sells its products, these transactions are reported as revenue, and the costs incurred to generate these revenues are expenses and are presented separately. However, if a manufacturing company sells surplus land that is not needed, the transaction is reported as a gain or a loss. The amount of the gain or loss is the difference between the carrying value of the land and the price at which the land is sold. For example, in Exhibit 2, Kraft reports a loss (proceeds, net of carrying value) of $6 million on divestitures in fiscal 2009. Kraft discloses in the notes to consolidated financial statements that the assets sold included a nutritional energy bar operation in the United States, a juice operation in Brazil, and a plant in Spain.

The definition of income encompasses both revenue and gains and the definition of expenses encompasses both expenses that arise in the ordinary activities of the business and losses.6 Thus, net income (profit or loss) can be defined as: a) income minus expenses, or equivalently b) revenue plus other income plus gains minus expenses, or equivalently c) revenue plus other income plus gains minus expenses in the ordinary activities of the business minus other expenses, and minus losses. The last definition can be rearranged as follows: net income equals (i) revenue minus expenses in the ordinary activities of the business, plus (ii) other income minus other expenses, plus (iii) gains minus losses.

In addition to presenting the net income, income statements also present items, including subtotals, which are significant to users of financial statements. Some of the items are specified by IFRS but other items are not specified.7 Certain items, such as revenue, finance costs, and tax expense, are required to be presented separately on the face of the income statement. IFRS additionally require that line items, headings, and subtotals relevant to understanding the entity’s financial performance should be presented even if not specified. Expenses may be grouped together either by their nature or function. Grouping together expenses such as depreciation on manufacturing equipment and depreciation on administrative facilities into a single line item called “depreciation” is an example of a grouping by nature of the expense. An example of grouping by function would be grouping together expenses into a category such as cost of goods sold, which may include labour and material costs, depreciation, some salaries (e.g., salespeople’s), and other direct sales related expenses.8 Both Danone and Kraft present their expenses by function, which is sometimes referred to “cost of sales” method.

One subtotal often shown in an income statement is gross profit or gross margin (that is revenue less cost of sales). When an income statement shows a gross profit subtotal, it is said to use a multi-step format rather than a single-step format. The Kraft Foods income statement is an example of the multi-step format, whereas the Groupe Danone income statement is in a single-step format. For manufacturing and merchandising companies, gross profit is a relevant item and is calculated as revenue minus the cost of the goods that were sold. For service companies, gross profit is calculated as revenue minus the cost of services that were provided. In summary, gross profit is the amount of revenue available after subtracting the costs of delivering goods or services. Other expenses related to running the business are subtracted after gross profit.

Another important subtotal which may be shown on the income statement is operating profit (or, synonymously, operating income). Operating profit results from deducting operating expenses such as selling, general, administrative, and research and development expenses from gross profit. Operating profit reflects a company’s profits on its usual business activities before deducting taxes, and for non-financial companies, before deducting interest expense. For financial companies, interest expense would be included in operating expenses and subtracted in arriving at operating profit because it relates to the operating activities for such companies. For some companies composed of a number of separate business segments, operating profit can be useful in evaluating the performance of the individual business segments, because interest and tax expenses may be more relevant at the level of the overall company rather than an individual segment level. The specific calculations of gross profit and operating profit may vary by company, and a reader of financial statements can consult the notes to the statements to identify significant variations across companies.

Operating profit is sometimes referred to as EBIT (earnings before interest and taxes). However, operating profit and EBIT are not necessarily the same. Note that in both Exhibits 1 and 2, interest and taxes do not represent the only differences between earnings (net income, net earnings) and operating income. For example, both companies separately report some income from discontinued operations.

Exhibit 3 shows an excerpt from the income statement of CRA International (NASDAQ GS: CRAI), a company providing management consulting services. Accordingly, CRA deducts cost of services (rather than cost of goods) from revenues to derive gross profit. CRA’s fiscal year ends on the last Saturday in November, and periodically (for example in 2008) its fiscal year will contain 53 weeks rather than 52 weeks. Although the extra week is likely immaterial in computing year-to-year growth rates, it may have a material impact on a quarter containing the extra week. In general, an analyst should be alert to the effect of an extra week when making historical comparisons and forecasting future performance.


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